For Tuesday, Jul 12, the market forecast is uncertain

July 11, 2011

We recommend selling your equity positions.

Subjective Comments:

For investors, there is a lot of frightening financial and political news going on. We strongly urge caution. Sell your equity positions and hold cash, not money market funds. Holding cash is a short term recommendation and we’re not suggesting moving all assets into cash. We are suggesting equities (stocks) and bonds should be moved to cash for the next few weeks while the storylines in progress play out.

There are three unfolding turning points, all of which will eventually impact the US markets. What is unknown and difficult to subjectively predict is timing. These three crises are:

European Debt Crisis

US Debt Ceiling

Price Inflation in China

Europe

The problems in Greece a few days ago have not been resolved. A very short-term loan was agreed upon to prevent Greece defaulting on its next bond payments. No sooner was that deal done than the debt problems in Italy and Spain have caused turmoil. The countries of Portugal, Ireland, Italy, Greece and Spain (PIIGS) are in too much debt and will be unable to continue payments on their bonds. They will default. The news headlines will be full of quotes from politicians and bureaucrats as they desperately attempt to delay the day of reckoning. Assume every other statement forthcoming is a lie or half-truth. The defaults are coming and it will get ugly.

USA

The US is in little better position than the PIIGS of Europe. As Congress and the President attempt to create an agreement on the debt ceiling, remember that it has been raised over 90 times in the past 90+ years. They’ve never failed to raise it. It’s a good bet they will raise it again. The US will eventually default on its debt, but by lifting the ceiling the US can delay the day of reckoning a little longer. How much longer is not certain, but probably longer than Europe. We think during July and August the US Stock Market will drop, thus providing justification for more Quantitative Easing (money printing) by the Federal Reserve. (Technically, money printing is a form of default.)

China

Price inflation is raging in China. It is showing up mostly in commodities which is very difficult for consumers who spend a large portion of their incomes on food. The provinces are broke and have been bailed out by the central government in a TARP-like program larger than the 2008/09 TARP in the US when measured as a percent of GDP. The Chinese GDP boom has been fueled by massive construction. Sadly, it has been building bridges to nowhere and ghost cities. Local officials have been evaluated by their contribution to GDP, incentivizing huge construction projects the people will never use. This has been enabled by growth in the Chinese money supply. The People’s Bank of China has raised rates and increased bank reserve requirements to reverse the price inflation caused by the money supply growth. This slowing of the money supply will trigger a bust. Predicting when is a guessing game, but we think it will happen before the end of this year. A report from Reuters has the following story:

The China Daily cited Yuan Shuhong, deputy head of the Legislative Affairs Office of the State Council, China’s cabinet, as saying that the political outlooks of local leaders would dim if governments borrowed excessively during their terms of office.

This is a big deal! Local leaders were incentivized to grow GDP by borrowing excessively. Now those same local leaders get this chilling message, scapegoating them for doing what they were previously directed to do. Borrowing in China is about to come to a screeching halt with a liquidity freeze caused by the slowing of the money supply and this threat to the “political outlooks” of the local leaders.

Conclusion

We think the debt crisis in Europe is erupting and there is little that can be done to cover it up any further. They will try, but it will probably be the first crisis to really get bad. The bust in China will happen, probably after Europe but before the end of the year. Both events will have an impact in the US. The US politicians and bureaucrats will probably use these as opportunities to shift attention away from the US debt problems. Eventually the US will be unable to auction off all of its Treasury bonds, like just happened in China. It’s not clear how long until that happens, but eventually it will. The only uncertainty is timing. That these debt problems will crash markets is unavoidable. The ability of the authorities to delay the inevitable is questionable. We’ve guessed at the order, but who really knows? This is why cash is a good idea for the next few weeks.

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